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Monday, February 25, 2013

Negative Interest Rates

First of all, sorry for being one day late. I was in Sydney for Soundwave yesterday and did not have access to a computer. Secondly, today's post will not be about P/B ratios. I'll write about them next Sunday :P

So about a week ago I was having a lovely conversation with a friend, we got along quite well and our conversation seemed to flow seamlessly from one topic to another. So for some reason we ended up talking a bit about Japan, about their economy and mentioned something about negative interest rates. It is something that I’ve heard about but never really did any research on. So after the conversation I’ve decided to so some homework and study a bit about interest rates.

Basically interest rate is the rate that is paid by borrowers to borrow money from a lender. So if I lend you 100 dollars and say you have to pay me back 110 in 6 months, the interest rate would be 10/100 x 100 or 10%. Interest rate targets are set by central banks or reserve banks to try (I emphasized ‘try’) and deal with things like investments, be it in businesses or shares, inflation and unemployment.

Generally, interest rates are reduced to encourage investments and consumption. This makes sense because if interest rates are low, it becomes a disincentive to hold cash. If you have cash that is making you 2%, why not put it in a company that could earn you 5% in dividends and potentially more in capital gains. Low interest rates also give people access to cheap money. So it means I can borrow more money because interest rates are low, I only have to make a small amount from that money to cover my cost.
As you can imagine, this theoretically can stimulate the economy a bit and when there is more money around, things start to become more expensive, i.e. inflation. Then the central banks will increase the interest rate targets to try and catch up with inflation, encourage people to save more cash and make it more expensive to borrow money.

There are two main types of interest rates; real and nominal interest rates.

Nominal interest rate is the amount of interest payable so like before, if you make a deposit of 100 dollars and get 110 at the end of the year, the nominal interest rate would be 10/100 x 100 or 10%.

Real interest rate tells us the purchasing power of the interest because it takes into account inflation. So if you make 10% interest from your deposit but prices of food went up by 10% in that same year, your purchasing power did not actually increase and your real interest rate would be 0%.

So back to Japan and negative interest rates. From the very little reading that I’ve done, negative nominal interest rates are a very very rare occasion. Whereas negative real interest rates are a lot more common. You can imagine if the interest rate is close to zero say 1% and inflation for the year is 2% a -1% real interest rate is quite easy to imagine, you don’t actually lose money by putting your money in your bank, you lose buying power (which is sorta the same thing at the end of the day).

However can you imagine actually having negative nominal interest rates? Meaning if you deposit money in a bank, you’ll get less out when you withdraw it. Something like this happened before in Sweden back in 2007 when Sweden’s central bank, Riksbank, reduced its interest rate to -0.25%, requiring banks to pay that amount on the money that they have deposited in the central bank.

Something like this has also happened in Japan for a short while when investors who bought short-term Japanese Government bills made negative yields. (Keep in mind we’re talking about central banks and government bonds, we’re not talking about consumer banks, I cant imagine what’ll happen if consumer interest rates ever become negative.)

I think it is fascinating and a bit scary that things can get so bad that you’d rather lose money by holding cash than put money into other investment vehicles like properties and shares to avoid the risk of losing more.

Thanks for reading, feel free to drop me an email or leave a comment if you anything to add, correct or clarify about the post.